Insight & Analysis

Future of letters of credit not guaranteed

Published: Aug 2021

Digitisation of trade finance is expected to accelerate the development of alternatives to the letter of credit.

Business man using paper pad and electronic tablet

At first glance, the case for digitising letters of credit appears to be a strong one. Surely it makes more sense to improve an existing legal and commercial structure rather than adopt a different one?

Yet the corporate treasurer of a Scandinavian technology company that participated in a co-creation project aimed at digitising the export letter of credit process earlier this year, admits that the benefits from digitisation might not be enough to justify the cost of implementing systems able to handle digital letters of credit and presentation of digitised documents.

With adoption of digital letters of credit being held back by limited standardisation and interoperability, an opportunity arises for the development of alternative solutions.

According to Marie-Laure Gastellu, Head of Trade Services Transaction Banking at Societe Generale, technologies such as blockchain allow banks to design new instruments and ecosystems to support the need to secure and finance trade operations – especially among SMEs – while reducing the constraints and costs of traditional instruments such as the letter of credit.

There are obvious obstacles to developing these alternatives instruments, such as building a new legal infrastructure that can be accepted by all banks and corporates globally without a global regulatory mandate.

However, Alex Goulandris, Co-CEO of essDOCS reckons there is room for both. “The letter of credit is a widely used trade finance instrument, so digitising processes that the industry is comfortable using is a logical step,” he says. “But we also expect to see significant growth in instruments that rebuild trade finance rather than just digitise paper processes over the coming years.”

An example of such an instrument is a digital payment undertaking, based on data matching or smart contracts which digitally compare data across contracts, purchase orders, invoices and bills of lading and automatically trigger a payment undertaking. This payment could also be made digitally in the form of a sovereign digital currency.

The first iteration of this was the bank payment obligation, which acted as an irrevocable trade instrument for securing payment on successful trade data matching. “We have seen a lot of new initiatives (including our own transaction matching application) focus on this segment using either the revised Uniform Rules for Bank Payment Obligations, ICC’s Uniform Rules for Digital Trade Transactions, or the BAFT Distributed Ledger Payment Commitment rules,” adds Goulandris.

In the long term, technology will play a key role in how risk mitigation and financing is offered to customers and consumed by industry suggests Venkatraman Panchapakesan, Global Product Head – Documentary Trade at HSBC.

“The shape and form in which letters of credit are offered will change, facilitated by developments in the technology space such as distributed ledger technology and smart contracts,” he adds.

Adoption of digital trade finance platforms is driving digitisation of letters of credit, but it is unrealistic to expect every organisation to make this transformation at the same time.

The danger is that this leads to a market filled with companies utilising different providers and software that may struggle to communicate with each other, creating a new barrier to an effective market, according to Contour CEO, Carl Wegner. “As businesses invest in technology to digitise letter of credit documents, they must adopt interoperable systems,” he says.

The form of certain documents that lie at the heart of international trade – including transferable documents such as bills of lading – is another obstacle. “Until these documents gain the legal certainty they need in electronic form, the widespread adoption of digital letters of credit will likely continue to lag,” concludes Lesley McNamara, Global Head of Trade Strategy in Global Transaction Services at Bank of America.

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